Role reversal for Japan’s banks

While the prospects for Japan’s megabanks look more exciting than they have done for many years thanks to strong balance sheets and adoption of global regulations, the outlook for the overcrowded regional banking sector is more uncertain.

Not so long ago, the popular perception was that Japan’s megabanks were characterised by an unflattering cocktail of weak growth, lousy prospects, uninspiring management and fragile capital ratios.

Today, their profile could scarcely be more different. The net profits of the five leading banking groups were up in the year ending in March 2013 for the fourth straight year. Their share prices have been turbocharged since the autumn of 2012, with most of them outperforming the Topix — which in recent months has taken some doing.

The banks’ capital ratios put those of many European banks to shame. “The balance sheets of the Japanese megabanks are now much stronger than their global peers, which is giving them an important competitive edge in international markets,” says Ken Takamiya, head of Asia-Pacific banks and other financials research at Nomura Securities in Tokyo.

How have they done it? “Simple,” says Yoshinobu Yamada, senior analyst in the global markets research department at Deutsche Securities in Tokyo. “First, they have adopted very low risk profiles. Second, they raised capital after the Lehman shock much more quickly than banks elsewhere in the world.”

Japanese banks began to implement Basel III in March of this year, and as Yamada says, the core equity tier one (CET1) ratios of the leading banks are already well above their targets. In the case of MUFG, CET1 is a little over 11%, while at SMFG and Mizuho it is 9.1% and 7.9% respectively. “The perception that the Japanese banks are vulnerable based on their capital adequacy ratios is clearly outdated,” says Yamada.

How to spend it

The question for Japanese banks today is how they should use the strength of their balance sheets to grow, and whether that growth should be in the domestic market or overseas. Certainly, over the last two decades growth opportunities in the home market have been pitifully restricted. Between 2000 and the end of 2012, according to the Bank of Japan, the gap between deposits and loans at the country’s financial institutions rose almost four-fold, from ¥60tr to ¥230tr.

It is easy to see why bank lending in Japan has nosedived over the last two decades. Shin Tamura, director and bank sector analyst at Barclays in Tokyo, says the decline can be traced back to the identification by the corporate sector of what he describes as “three excesses” — excess employment, excess capacity, and excess debt. Companies responded by cutting back on all three, and when they started to reinvest in manpower and capacity between 2005 and 2008, only those in the real estate re-levered in the process.

The effect on corporates was an unprecedented accumulation of cash, with Toyota — for example — recently reported to have some $37bn burning a hole in its pocket. That may be something of an exception, but more broadly about half of Japan’s listed corporates are debt-free, according to Shintaro Mori, co-head of capital markets and treasury solutions at Deutsche Securities in Tokyo.

The effect on banks, meanwhile, was two-fold. First, it drove loan to deposit ratios at Japan’s leading banks to exceptionally low levels by global standards. Second, with very few productive outlets for the cash they were accumulating, it led Japanese banks to acquire huge piles of Japanese government bonds (JGBs). “In a sense, it is banks’ deposits that have financed the deficit,” says Takamiya at Nomura.

Those large stockpiles of JGBs have periodically been a concern to equity analysts fearing that rising long term rates could leave Japanese banks vulnerable. Indeed, this was one explanation given by some analysts for the mini-crash at the end of May, when the Nikkei index retreated by over 7% in a single trading session.

Takamiya neatly describes the banks’ JGB holdings as “a clear but not a present danger,” and the danger is one that already seems to be dissipating. In April alone, according to BoJ data, JGB holdings at the major banks plunged by almost 11%.

Lending up at last

Domestic lending has started to pick up. At Barclays, Tamura identifies a number of areas where loan demand is growing. These include bridging loans for M&A, funding for electric power companies with intermittent access to the capital market, and support for local governments.

Nana Otsuki, bank sector analyst and head of financials at Merrill Lynch in Tokyo, agrees that Japanese banks are now moving into a loan growth phase, driven by two key factors. The first, she says, is the diminished uncertainty over capital regulations at the Japanese banks since their implementation of Basel III in March.

The second is the fresh impetus to lending which ought to be a by-product of the third arrow of Abenomics. “One of the main objectives of Abenomics is to promote more private sector lending to growth areas under the government’s plan to revitalise the economy,” says Otsuki, who estimates that Abe’s third arrow could fuel annual lending growth of 1.4%. Some of this growth, she says, will be in areas where Japanese banks have previously been reluctant to lend, such as healthcare, where recent reforms are giving lenders more access to borrowers’ collateral.

For the time being, however, the perception among the deep-pocketed megabanks is that opportunities in Japan pale into insignificance compared with those overseas, most notably in Asia. This explains why lending by Japanese megabanks’ overseas offices grew by 40% in the year to June 2013, compared with an increase in domestic branches of just 1.7% over the same period, according to Deutsche Securities.

There is nothing new, of course, about the Japanese banks flexing their muscles in the international market. But bankers say that this time around they are much better positioned to capitalise on opportunities overseas than they were in previous cycles. Barclays’ Tamura says that the key difference this time is that the Japanese banks are in more senior lending positions than their weakened US and European competitors. “In the 1980s the Japanese banks were in lending syndicates purely as providers of money,” he says. “Because they won very few lead arranger mandates they were unable to establish long term banking relationships. Today, they are acting as arrangers and advisers to many leading borrowers.”

Asia focus

At Deutsche, Yamada says he is confident that Japanese banks will not expose themselves to unnecessary risks in international markets. “My estimate is that about a third of the banks’ overseas lending is to affiliates of Japanese companies, mainly in Asia,” he says. “For example, there are about 6,000 Japanese companies with subsidiaries in Thailand alone.”

“The next one-third of lending is to top-rated multinationals, and the remaining third is dominated by syndicated facilities to key infrastructure projects. So I have no concerns about the asset quality of Japanese banks’ international exposure,” adds Yamada.

Others seem equally relaxed on this score, although Otsuki at BAML says that it is precisely the quality of their overseas loan books that may exert some downward pressure on the international earnings of the Japanese banks. “The perception is that lending overseas is much more profitable than it is in Japan, but this is not true,” she says. “Funding costs are higher, because loan-to-deposit ratios are much higher overseas, and net interest margins are less attractive than people assume.” Specifically, she says the average interest margin on overseas lending at the top three banks is between 1% and 1.2%.

Be that as it may, the leading Japanese banks are anything but bashful about their international ambitions. “We aim to grow from a megabank based in Japan to [a] globally active diversified financial services group with Asia as our home market,” is the uncompromising objective outlined in a recent presentation from SMFG. The ambition of transforming the group from being “Japan centric” to “Asia centric” is one that is shared by all three of Japan’s megabanks, and has been reflected in a number of recent acquisitions.

One of the most recent examples is the announcement from BTMU at the start of July of its voluntary tender offer for up to 75% of Bank of Ayudhya (Krungsri), Thailand’s fifth largest bank. The offer, which is due for completion in December 2013, will be the largest acquisition in Asia to date by a Japanese bank. According to BTMU, this will “accelerate [the bank’s] Asian growth strategy through the expansion of retail and SME banking business along with further expansion of corporate business banking.”

“The focus of the Japanese banks’ acquisitions is always on creating synergies,” says Yamada at Deutsche. “They will focus on following their corporate clients into markets like Thailand where Japanese businesses are strong.”

Wither the regionals?

While the prospects for Japan’s megabanks look more exciting than they have done for many years, the outlook for the overcrowded regional banking sector is more uncertain. As Nomura’s Takamiya says, the pursuit of growth among the megabanks may turn the competitive heat up on Japan’s 64 regional banks, which between them have 7,500 branches and deposits of just over ¥228tr.

In early August, it was reported that two listed Tokyo-based regional banks, Tokyo Tomin and Yachiyo Bank, were considering integration talks. If these come to fruition, the newly merged entity would be the sixth largest regional bank in the Kanto region, with combined deposits of around ¥4.4tr, over 160 branches and 1,600 employees.

At Barclays, Tamura cautions against reading too much into the reported talks between Tokyo Tomin and Yachiyo, which, he says, command very modest market shares of 0.9% and 0.5% respectively. He explains that the government enacted legislation as long ago as 2003 designed to encourage more integration between regional banks, but that precious little has happened by way of consolidation since then. “We may see more integration 10 or 20 years from now,” he says, “but as long as even the weakest banks see their deposits continue to grow, they have little incentive to realign.” s